Inflation - what would Milton say?

J.P. Szafranski, BridgeTower Media Newswires

“Inflation is always and everywhere a monetary phenomenon,” legendary economist Milton Friedman famously posited. His “monetarist” point of view was that the amount of money circulating in an economy was the most important factor in determining inflation and economic growth.

Mr. Friedman passed away in November 2006. He did not get to observe the U.S. Federal Reserve’s response to the Global Financial Crisis later that decade. As the Fed’s preferred policy tool (the Fed Funds Target Rate for overnight bank lending) approached the zero-bound, then-Chair Ben Bernanke began purchasing longer-term securities to be held on the Fed’s balance sheet. Funding securities purchases with newly created dollars is commonly known as quantitative easing (QE). The Fed’s balance sheet ballooned from less than $1 trillion to over $4.5 trillion in assets by the middle of the next decade.

This massive infusion of cash into capital markets undoubtedly inflated financial asset prices, all else equal. However, since previously over-leveraged households and financial corporations alike focused on reducing their debt, much of this liquidity didn’t make it into broader economy. In many cases banks simply exchanged one asset for another with the Fed during QE, trading Treasury bonds for excess bank reserves sitting idly at the Federal Reserve Bank. Therefore, the impact to money in circulation in the economy was muted and inflation readings remained mostly benign.

Fast-forward to the onset of COVID. By the end of last decade, the Fed managed to reduce its balance sheet to around $4.2 trillion in its attempt at “normalization.” According to Fed data provided by Bloomberg, the latest reading now sits at $8.3 trillion. The Fed understandably reacted to the unprecedented economic shutdown in 2020 with unprecedented monetary stimulus. Financial markets were certainly “saved” by this fresh wave of monetary stimulus, combined with massive fiscal stimulus from Congress and the executive branch.

Is it possible for us to collectively to benefit from all this stimulus without any related trade-offs? That would be pure fantasy. One likely collective cost will be through sustained higher inflation. M2 money supply has spiked by about 33% since the beginning of 2020. By way of comparison, M2 rose by less than 10% over a comparable time frame after Lehman Brothers collapsed in 2008. Milton Friedman would probably be concerned.

Current Fed officials feel sanguine about inflation, however, according to their June meeting minutes: “Recent 12-month change measures of inflation ... were boosted significantly by the base effects of the drop in prices from the spring of 2020 rolling out of the calculation. In addition, a surge in demand as the economy reopened further, combined with production bottlenecks and supply constraints, contributed to the large monthly price increases.” Their position is supported by current data showing elevated airline fares and used car prices significantly impacting recent inflation readings like the Consumer Price Index (CPI). These factors should indeed prove to be temporary.

What might not be so temporary, and very importantly is hardly even showing up in the data yet, is the cost of housing. CPI uses “Owner’s Equivalent Rent” to factor in housing cost for the two-thirds of households that own their own home. This causes a lag between actual increases in housing costs (see: 16.6% annual increase in nationwide housing prices as of May 2021 per S&P CoreLogic Case Shiller) and what official inflation measures reflect. Future increases in “Owner’s Equivalent Rent” look like they are inevitable. It’s hard to project how and when the Fed will react to sustained higher inflation. One thing I’m sure of is that the bill is coming due. We are all on the hook for it, and I fear that those of us with the least amount of assets and income will feel it the most.

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J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com).